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Barron's Features

Cracks in The Nifties

By

Kathryn M. Welling

Sept. 7, 1998 12:01 a.m. ET

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A n Interview With Fred Hickey and William Fleckenstein ~ Neither pretends he didn't underestimate the impact over the past couple of years of the stampede into the narrowing circle of big-cap tech stocks that led the bull market's massive advance. Both Fred, who pens the High-Tech Strategist newsletter from Nashua, New Hampshire, and Bill, whose Seattle-based Fleckenstein Capital's main line is running a hedge fund that shorts tech issues, expected the tech bubble to pop well before now. Said so, in this magazine. Both, however, have also been pragmatists enough -- not to mention in touch enough with the tech scene -- to keep their portfolios in the plus columns in recent years.

But now, suddenly, the cracks they've long predicted have started to appear. We placed a transcontinental conference call late Wednesday, just to find out what they make of the recent action. Wouldn't you know, they're not about to underestimate the downside for what Fred calls the Nifty Techies -- or for the market.

Barron's:Admit it. Even though a lot of small techs have been taking drubbings since last fall, you both waited a lot longer than you expected to see the big-cap tech stocks start to crack the way they did last Friday and Monday.

Fleckenstein: As a practical matter -- and since I run a hedge fund, I have to be a pragmatist -- let me respond by pointing out that, if you have been reading in Fred's letter about what has been occurring, fundamentally, in the industry, you have to acknowledge that he's been dead right. The problem for investors has been, and it always is, that markets are irrational and there has been a real love affair with technology stocks because a lot of people have made a lot of money -- and this isn't the first cycle that this has happened. We saw it in the early 'Eighties. Then it soured -- and both Fred and I were long a lot of these tech stocks in 1990-91, when you couldn't give them away. But this religious fanaticism toward technology has created a certain amount of bias and spin on Wall Street's part, where what matters isn't so much the facts as what people want to believe, what the cheerleaders say is going to happen next. There's also been a certain amount of good old-fashioned less-than-the-truth -- managements telling people what they want to hear. As an investor, you had to get the facts right -- and get the spin right.

Hickey: Your check is in the mail. You alluded to the other phenomenon we've seen as the technology market's fundamentals have deteriorated over the last three years -- as PC sales growth (in dollar terms) has slumped from 20% -- plus to nearly nothing, year over year; as networking sales growth has dropped from 48% to single digits over the last two years; as annual semiconductor sales have dropped from a grand total of about $150 billion to $120 billion; as semiconductor-equipment markets have collapsed-the book-to-bill ratio, at .69, is probably the worst we have seen in 10 years. That phenomenon is that the smaller tech stocks have really taken it on the chin. They generally are the weaker companies in the industry, feel the pressure first. What has happened is that as, say, virtually every semiconductor company has come apart, it has forced investors -- who wouldn't give up on technology -- into the momentum stocks. Into the larger-caps, which therefore are holding up better. The upshot is that a handful of semiconductor stocks, like
Intel
, are still up on the year, despite deteriorating fundamentals. In semiconductor equipment, you have
Applied Materials
defying gravity while companies like
Lam Research
sell below book and cash value. Applied Materials' shares, by contrast, are nearly as high as they were in '95, at the equipment market's peak.

Fleckenstein: Trading at about eight times annualized sales.

Hickey: Companies like
Dell Computer
and
Cisco Systems
have enormous market valuations and have shown scarcely any weakness, not only because they've been able to gain market share, but because when everybody has run out of all the other techs, they've gravitated into those "safe havens." Last Wednesday [August 26], when the market was down, we had 141 new lows in computer and electronics -- and two new highs, Dell and Cisco.

Fleckenstein: Intel is another example of this disconnect between fundamentals and market valuation. Intel reported earnings of 69 cents a share last quarter. The last time their earnings were in the 60s was the second quarter of 1996. They just reported their second consecutive quarter of down year-over-year revenues in probably about 10 years. Yet the stock sells at six times revenues. Anyone can see that Intel has virtually no market share in the sub-$1,000 retail PC market, one of the fastest-growing areas. All the key insiders are selling stock in a very chunky fashion -- many making their first sales in years. They started missing numbers in June of '97, so their mispositioning and overcapacity relative to the processor market was already happening before Asia went into the tank. Yet before this market started to crack about 10 sessions ago, this thing was back up to 92, barely 10% off its all-time high. That shows you the difference between getting the fundamentals right and dealing with Wall Street's cheerleaders.

Hickey: It's even worse. Intel in the last quarter saw gross margins fall 12 points, year-over-year. Any other company in any other industry wouldn't have seen its stock rise. Intel's unit sales were estimated to be down by a couple of hundred thousand, year-over-year, in that quarter, while
Advanced Micro Devices
were up by a million -- Intel lost four percentage points of market share in the period. Yet the stock is up on the year. It's hard to believe.

Q : Except that everyone has been piling into what you call the Nifty Techies.

Hickey: Yes, and as of noon [September 2], those just 10 names still had a market value of nearly $1 trillion -- Dell,
Microsoft
, Intel,
IBM
,
Lucent Technologies
, Cisco,
Compaq Computer
,
Hewlett-Packard
,
Motorola
and
Oracle Systems
. They were still up 38% on a year-to-date basis and 92% higher than where they began 1997. And even within that group, some are not performing well, like Motorola, H-P, Oracle. But Dell is up 173%. Lucent is up over 100%. Cisco and Microsoft are up 60%-plus this year. We are down to, really, a handful of stocks that are driving the S&P 500 -- and the Dow, too, courtesy of IBM. Just consider the Nifty Techies' performance next to even the heavily tech-weighted Nasdaq 100 Index, which is up about 20% this year -- or the Russell 2000's 20% decline. And the money involved in these few names is so large, a trillion dollars out of the market's total capitalization of $12 trillion, that its impact surpasses even that of the losses we've seen in the thousands of little companies hitting new lows. While it's getting hard to find mutual funds that have made money this year, many mutual-fund holders haven't felt a whole lot of pain yet because successful portfolio managers have been so concentrated in the Nifties. Take the
Legg Mason Value Fund
, for instance. It was still up 11% at the end of last week -- and about 9% of its $5.5 billion in assets are in Dell.
Janus Twenty
was up 33% and has over 10% of its assets in -- guess what? Dell. That's the risk.

Q : You're implying that the Nifty Techies aren't really safe havens?

Hickey: Exactly. The risk is not in the thousands of companies now selling at book value as a result of the slaughter over the last several months. The risk is that these few names go down.

Fleckenstein: Another phenomenon at work here: Those same few names "act well" so they attract the scores of day traders. What you saw in the last couple of days was the first taste of a little forced margin liquidation -- and how fast these things can get slaughtered.
Amazon.com
, just to pick a name, after having been so bulletproof, was cut in half in four days. Traded down from around 120 to the 60s or so. That is something, I think, that the public doesn't appreciate about the way the market really works -- fast -- and how violently things can go down. There's an illusion of strength and stability as all the funds and day traders pile into the same narrow list of names. The fact is the opposite. When they go, they just go.

Q : No one is left to buy them.

Hickey: You are describing the liquidation phase of a bear market, typically toward the end. That's what happened in the 'Seventies. That's what happened in 1990's minor bear market, when Intel and Compaq lost half of their value in 12 weeks. Compaq, at that time, was the most successful PC company in the world. In 1987, Compaq lost a similar amount and Intel lost two-thirds of its value in the liquidation phase.

Q : Isn't it a little early here to be talking about the liquidation phase?

Hickey: Yes, we've only begun to crack investors' confidence in the Nifties. You can't have the kind of euphoria where online investors are using screen names like "Dell-icious" and signing postings "Dell Forever!" and be at the bottom.

Fleckenstein: The last few days have been the first time that anyone's been forced to sell them. I've heard enough stories about margin calls that the average investor is beginning to get a glimmer of the notion that Wall Street has been selling them a bill of goods. Not to pick on Intel, but what people still don't realize is that it'll be lucky if it only drops to 40 -- where it sold the last time its quarterly earnings were in the 60-cent range. At that point, its business was accelerating, not decelerating.

Hickey: I've tracked Intel stock for 13 years now, weekly. I do it by hand.

Q : Some high-tech strategist you are!

Hickey: I'm out of touch in many ways. But it can tell you a lot. My nice hand-charted numbers include Intel's P/E ratio. Over the last 10 years, it has ranged between 9 and 20, never over that. Where is it now? At 25 times estimated earnings.

Q : The bulls argue that PC sales are about to revive.

Fleckenstein: For two years running, Wall Street has manufactured this strong second-half theme. That they're still trying to believe it is remarkable, since PCs are the biggest commodities in technology. Micron Electronics, Hewlett, IBM, Gateway 2000 have all missed scads of earnings estimates. The only one to come through clean as a whistle, so far, is Dell. But now basically the whole world is slowing, not just Asia. The bulls' favorite story is that we only export tiny amounts to one country or the other. But they miss two points: A) It's cumulative. B) It's not just about exports. It's about the destruction of capital. A lot of hedge funds have been destroyed. The banks have taken huge hits. That takes the wherewithal to do things out of the market -- and the economic impact moves back up the food chain. It just takes a while. That's why all the people who said Asia didn't matter were wrong. They didn't allow enough time. Now Windows 98 has come and gone. It wasn't a particularly strong driver. Windows NT won't have any real impact until 2000. We have no new hardware drivers and the world economy is slowing down. Yet people see a magical increase in PC sales. The only thing that will boost PC sales is lower prices -- and even that won't have much impact, at some point. Bulls believe nothing bad can happen until the Fed raises interest rates to fight inflation. They totally miss the possibility that we have way too much capacity and, with the bubble popping, are going to have a slowdown without rising rates.

Hickey: Also, no one has factored the risk of a recession into the price of Dell. Or of the implosion of the stock market bubble. We had Gateway's CEO, Ted Waitt, on a conference call today, saying everything is wonderful. But he admitted that when the stock market fell apart on Monday, his calls dried up. If the bubble pops, consumer demand could drop off fairly dramatically. I think that is coming. No one factors that risk into Dell's price. We've never seen such a valuation in the industry -- or worse conditions in the industry.

Fleckenstein: Stack up Dell's recent market cap of $80 billion against the entire PC industry's annual sales of $160 billion. When it goes, it'll be just like Amazon, bing-bing.

Hickey: Quicker than other favorites have, historically, because there is no book value there.

Q : Book value? You are out of touch.

Hickey: A traditionalist. Funny, but it seems like these thousands of small techs that have been slaughtered are finding some sort of bottoms when they hit book value. Like Lam Research. Right now, in Dell, you are buying the concept that its earnings will grow at a 50% or higher rate forever. But they won't. Just the law of large numbers will not allow that. At some point, Dell will slow down. But all that has to happen to take down the stock is for confidence to start to erode. When Compaq was slaughtered in '87, it was still growing at 200%. Investors just started worrying about a recession in the aftermath of the crash. When the confidence game ends, valuation will become important again. And in Dell's case, there is virtually no book value.

Q : How can that be?

Hickey: All the money they've earned in the last decade, which in theory should be piling up in the form of assets of some sort or another, has gone out the door almost every quarter. Dell has used up to 75% of its cash received every quarter to buy back the most inflated stock in the most inflated stock market in history.

Q : Without increasing book value?

Hickey: Because they've issued so many stock options to executives and employees. If I were a Dell shareholder, I'd be very unhappy that the assets it earns are being looted.

Fleckenstein: All the tech companies are doing buybacks. Their huge option grants are a way of paying employees while inflating earnings, because their compensation washes through the balance sheet instead of the income statement.

Hickey: No one cares about valuation until something goes wrong. When
Computer Associates
, a couple of months ago, warned of a possible slowdown, the stock was immediately halved. Only then came the uproar about all the options it had granted. In early 1995, Dell's stock price was about $3 and its book value, almost $1. Today, the stock is north of $100 and book is $2.30 -- it's trading at almost 50 times book. Historically, stocks trade at two to three times book. Even in this mania, stocks trade at about six times book today. But Dell has issued so many shares to employees that it has legions of multimillionaire secretaries -- or retired secretaries. Michael Dell is one of the richest guys in the world with an $11 billion stake in the company -- even as he has sold shares worth more than $100 million in the past couple of months. Lots of other executives are unloading, too. Wouldn't you, at $100? If confidence goes, and Dell ends up priced like PC companies in the past, those shares will drop to something close to book.

Fleckenstein: True. But at least Dell knows what business it's in. That's better than Gateway, which started out with a good idea and executed it pretty well for a while, but in the last couple of years, they've missed numbers, gone astray. Their big-screen TV/PC was a total flop. Now they've got a country-store concept, a gigantic misuse of corporate cash in the retail market for a company that's supposed to be a direct seller. They have steadfastly refused to address the low end of the market. They are moving their headquarters to Southern California -- which is obviously cheaper than South Dakota.

Q : We take it you're not a fan.

Fleckenstein: They're also in the process of building a direct corporate sales force, and just missed earnings again -- by 15%. Ted Waitt at this stage last quarter was assuring everyone earnings were okay. Why anyone takes them at face value is beyond my comprehension. Ted has also been selling a lot of his stock. His mother didn't raise a dummy. Fact is, I don't see why Gateway should exist, prospectively. Dell is expensive, but they have executed. Even Hewlett has executed. It has problems because of the dogfight among all the PC makers.

Hickey: Because the PC market isn't growing. Even IDC says sales are going to grow only 4% this year. It'll be less, because selling prices are dropping more. In order for Dell to grow at 50%-60% a year, they need to steal market share. They're stepping on everyone's toes and all the other guys are trying to attack Dell's flank.

Q : Aren't some big companies starting to place big PC orders to get around Y2K issues?

Hickey: That doesn't show up in any of the numbers. Corporate resellers' sales growth slowed sequentially in the second quarter. The corporate resellers say they haven't seen an impact from Y2K. And there's one indicator of corporate PC sales trends that is almost infallible -- it's called corporate profits. Ed Hyman of ISI Group has charts showing that every spike up in corporate profits corresponds with a spike up in capital spending and viceversa -- and PC sales have been amounting to half of capital spending. So now the Commerce Department says corporate earnings fell 1% in the second quarter. Lo and behold, we have PC sales falling. What's more, we have seen a lot of trouble recently in semiconductor and component suppliers to non-PC areas, indicating that something's going on beyond just the slowdown in PCs.

Fleckenstein: The next big bombs are going to go off in semiconductor-land. The
Maxim Integrated Products
and the
Linear Technologys
of the world still sell at about eight times revenues. They are "not in the PC business." But their end markets are going to be impacted by declines in everybody's GDP.

Hickey: Like
VLSI Technology,
which has tried to go out of PCs into networking -- where we are seeing weakness now.

This morning two contract manufacturers with very few ties to the PC market preannounced lower sales and earnings. Their businesses are heavily weighted towards telecom. We are likely to see a lot of preannouncements from these non-PC techs this quarter.

Fleckenstein: And when you really look at these supposedly bullet-proof semiconductor stocks, they turn out to be more expensive than, for example, Coke and Gillette. Even though those blue chips have higher P/E multiples, they've also had expanding margins. These tech hardware companies are all high-fixed-cost businesses. Losing a little bit of revenue does disproportionate damage to their bottom lines. There is no cheapness in semiconductor hardware. They are much more prone to disappointments because they are GDP-sensitive.

Hickey: Another thing to consider is that these techs have had tremendous success exporting. So this industry has more exposure to overseas turmoil than almost any other. Over 60% of PCs are sold outside of the U.S., mostly by U.S.-based companies. And almost a quarter of those go into the Asia/Pacific region. Half of all semiconductors go into Asia. Some end up in end markets elsewhere; still they go there. Asia dominates demand for semiconductor equipment.

Fleckenstein: Tech companies are really at ground zero of all the problems.

Q : How much overcapacity is there?

Hickey: Take, for example, Taiwan, whose economy has held up -- relatively -- though the government is lowering its growth forecast now. Most of Taiwan's major electronics companies have been slashing their '98 earnings forecasts by 40%-50% over the last two weeks.
Acer
cut its forecast by 36%,
UMC
by 42%. These are very large companies. At Taiwan Semiconductor, the world's largest foundry, sales fell 16% in July -- after averaging a 48% increase earlier in the year. Taiwan's stock market has cratered. The government is saying they'll try to support it. But their earnings are falling apart because capacity utilization rates at Taiwan Semiconductor and UMC may be as low as 50%. That incredible overhang is causing huge pricing pressures. Things are worsening there as time progresses.

Q : That can't bode well for U.S. companies that sell to -- or compete with -- them.

Fleckenstein: People don't appreciate how hard semiconductor businesses really are to operate. We said a lot of negative things about Intel, but they did a damn good job of running their business for a long time.

Hickey: You also have to credit Micron Technology for surviving in a market where the Koreans are trying to kill off the Japanese and the Taiwanese, and the Taiwanese are trying to kill off the Koreans. It's absolutely brutal, the most commodity -- like market you could ever be involved in.

Fleckenstein: Considering which, Texas Instruments just tossed a drowning man an anvil, basically paying Micron to take fabs off their hands. So far, Micron has done a fairly good job. But they just bet the business on the DRAM market by levering up the balance sheet and issuing shares to take on the TI plants.

Hickey: In 1990 no one would touch tech names. The headlines said steel companies deserved higher multiples because tech was a terribly cutthroat business.

Fleckenstein: With no barriers to entry.

Hickey: Where margins will always be under pressure. Why would anyone pay more than five times earnings, never mind 75 times earnings, for it? At that point, the PC market was still in its relative infancy. Networking was hardly thought of. In another year, the industry started on this huge run. Today, however, tech is a much more mature industry. The problems people worried about in '90 are true today, they just don't know it. It's all upside down.

Q : You're saying tech is in a terminal decline?

Hickey: No. I'm a high-tech strategist. I don't see myself analyzing the next auto industry. This is a vibrant industry and there will be opportunities again.

Fleckenstein: There are just booms and busts in this business. And the bigger the boom ...

Q : We haven't talked software.

Fleckenstein: That is where the Y2K impact has been felt. In Computer Associates,
SAP
,
PeopleSoft
-- in many of the enterprise-level software suppliers blaming Y2K for project delays. No question, they benefited in recent years from companies deciding to replace mission-critical systems rather than upgrade them to cope with Y2K. But at a certain point, you're too close to Millennium Day to have time to install a new system. So the rush to upgrade inflated their numbers over the last few years. That's going to the other extreme now, creating a very difficult situation for these enterprise-level software vendors. Meanwhile, every PC software company has imploded, with the exception of the great monopoly.

Q : So, what about Microsoft?

Hickey: It's still the great monopoly, until the big government in Washington does something about it. Meanwhile, it continues to gain share.

Fleckenstein: The only negative about the big monopoly is that it's expensive as hell. They have done an excellent job at everything they have done. They are tough businessmen. On the other hand, it had a small-country GDP-like valuation until very recently.

Hickey: Back in July '97, the No. 2 guy at the big monopoly, Steve Ballmer, called its then-$180 billion market cap "laughable and beyond my imagination spectrum." Well, add $100 billion to that market cap -- that's where we are now. And their growth has slowed -- as they warn the analysts every quarter.

Q : They even stopped buying back their own shares.

Fleckenstein: They realize that their stock price is too high. They tell analysts at every opportunity. Unlike virtually every other company in this Nifty Techie environment, we can't blame Microsoft's management for trying to inflate its stock price.

Q : Are either of you tempted by the Internet stocks that have so recently been bloodied?

Fleckenstein: Ha, ha, ha!

Hickey: I am not laughing. I want to buy the stuff. But only after it implodes, and it certainly hasn't, yet. Every new group of stocks that comes around -- whether biotechs, minicomputers, PCs, whatever -- goes to the moon. Then, when the realization dawns that the market hasn't jelled yet, the pioneers all end up with arrows in their backs. After the slaughter, I'll pick up the survivors.

Fleckenstein: Part of the problem is perception. When you say the word Internet, people get doubly excited. That's why Amazon can sell dollar bills for 95 cents and still have a $6 billion valuation. But the Internet didn't just happen. It's been around since the late 'Sixties. What's new is that we put a powerful PC on everyone's desk and now people can interact via the 'Net. The affordable super-powered PC is what's new.

Hickey: The Internet is a great thing. It is Bill Gates' vision of information at your fingertips. Unfortunately, the bulls have taken it beyond that and now make claims that people will buy all of their groceries online. The first bad tomato they get, they won't buy groceries online. You have to be able to decide how you make money in this business. It hasn't been sorted out. And because by its very nature the Web is so wide open, it's hard to extract anything but the lowest margin from the consumer.

Fleckenstein: And people have the notion that if something has anything to do with the Internet, it ought to be free. Or as cheap as possible. An impediment to trying to make money.

Hickey: You have to think about the Internet as being the frontier. There is great opportunity out there. Someday. But there are also barriers out there. We still have not solved the bandwidth problem for the consumer -- and it doesn't look like we will, not in the next year, certainly. Maybe in two or three. There is great opportunity. The problem is that the stocks are all so overvalued, well beyond reality, that you can't buy them even if you want to. That will be the best part of this coming crash in technology stocks, including the Nifty Techies -- bringing them into buying range.

Q : When?

Fleckenstein: It could start any time. I expect the coming 'fess-up season to be particularly brutal. Some of these stocks may go down disproportionately because they're up on hopes the second half will prove better. It is not going to be very pretty.

Hickey: Let me take a little different tack. Up to here, the market decline has been tied to world economic events. Asia, the ruble. Worries about Latin America. They have been pretty much unpredictable. I don't think we really know exactly what is going to be the next trigger down. There are all kinds of potential problems from Mr. Clinton's troubles with Mr. Starr and Russia's tilt back toward communism to Latin American economies falling apart and lower corporate earnings taking capital spending down. A real recession. Who knows? I will say, though, that there's a possibility of the mirage of a rebound in the technology world continuing through this third-quarter preannouncement season.

Q : How so?

Hickey: Some of these companies might show improved results sequentially, although year-over-year will be terrible, just because the second quarter was so depressed as the PC vendors reduced channel inventories. So I can predict that the bulls will try to make the case again that all is well in the PC and tech world, though it isn't.

Q : We take it you both think it's too early to start bottom-fishing among the washed-out small techs?

Fleckenstein: Personally, just from a macro standpoint, I don't see any reason to want to own stocks, long, between now and the year 2000. Think about it. We have destroyed all this capital. It is clear we are going to have a slowdown in the world. A recession here, in all likelihood. You have all these ugly political crosscurrents. Then you are going to have the dislocations of dealing with Y2K. It's going to impact the power grid, the banks, Corporate America. Even if it isn't as bad as we might fear, it is going to scare people. There are plenty of catalysts to give us wonderful buying opportunities in late '99, early 2000. Unless we have an epic crash between now and then, you'll be better off sitting on your hands. Or maybe in gold stocks, though you'll laugh at me. Some of those stocks have been so bludgeoned that you can effectively buy gold at a steep discount via the stocks. But in general, why bother? Take 5% and come back in 15 months. You are not going to miss much.

Q : Fred?

Hickey: I can't speak to gold stocks, but I can tell you that, historically, whenever we've had a period of inflation in the large-cap tech names, it has not been safe to nibble on the small ones. Even though they've already cratered, they'll go even lower when big-caps come apart. So as long as Dell, Intel, IBM and maybe Microsoft and certainly Cisco -- these big balloons -- sit there, all you should do is spend time trying to identify which businesses will be required two or three years from now. Seeing what their balance sheets look like. So that when the turn comes, you'll be ready. And those opportunities will be worth the wait.

Fleckenstein: The whole purpose in trying to lay out this case is so that people can get out of the way. And get ideas for getting back in, when the risk/reward is better.

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